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Stock market investors and financial advisors hungry for positive returns haven’t had to look much further than the “all-you-can eat” buffet presented by the Federal Reserve and politicians for the past several decades. Low-slung interest rates and trillions of dollars in economic stimulus fattened equity portfolios.
That all changes Tuesday when the Fed meets to raise rates, with a half-point hike in view by Chairman Jerome Powell.
Many analysts are expecting a rate increase at every Fed meeting in the second half of 2022 – with further hikes next year.
The Fed is in a no-win situation: Raise rates and stifle the economy or don’t raise rates and watch inflation continue to soar. The Fed’s cupboard is bare – either scenario will result in drastically diminished consumer spending, which leads to reduced corporate earnings and lower public company valuations. Many drivers of the inflation eroding American consumption cannot be cured by rate hikes – supply-chain issues, the war in Ukraine, rising rents, energy costs, food prices, and health care costs. In addition, higher wages in a hot labor market could create a floor in prices for some goods and services, or worse create a wage-price spiral. Producer prices continue to far outpace employment rate gains.
Essentially, the Fed has to reduce inflation in certain areas of the economy and not do damage to others, yet its tools only impact certain sources of inflationary pain.
The inevitable outcome for equity investors, which now includes over half of all Americans, is a bear market. If you think it has been painful that the market has been down each of the past four weeks, your nest egg hasn’t seen anything yet.
American investors have figured out that you can’t have inflation and higher interest rates and a thriving consumer economy. Four out of five American adults are worried about a recession hitting this year. Current 30-year mortgage rates are above 5.3% and you can all but say goodbye to refinancing, a historical booster for the economy. And gas prices? Writing in the New York Times, Helen Thompson of Cambridge University said it’s not just high oil prices but a full-blown energy crisis created by bad policies.
Many wrongfully assume that the economy is in good shape because of the low unemployment rate. Getting a job is not the hard part these days – what is hard is filling jobs. There are 11 million unfilled jobs in the United States right now – positions that if filled would drive spending and growth, but remain open largely due to an aging population. Even President Biden’s commerce secretary has said that the aging of America will hit the economy like a “ton of bricks.”
For the more than half of Americans invested in the stock market for retirement, college, or life’s other financial milestones, the hedge to a bearish stock market has historically been the so-called safe haven of bonds.
Modern portfolio theory has long espoused a diversified asset mix of stocks and bonds, with a 60% stock and 40% bond model becoming the dominant mix for portfolios. But that 60/40 split is a losing proposition on the bond side, as yields are far below inflation and many bond categories are failing to deliver on their traditional roles of capital preservation, income and diversification in a portfolio.
Investors are seeking other options, evidenced by the fact Morningstar’s options-trading category is one of the fastest-growing investment categories. This category includes hedged equity solutions that serve long-term investors seeking the benefits of remaining invested in equity markets while mitigating risk. Hedged equity involves buying equity in some form – an underlying investment such as the S&P 500 – and securing a hedge to offset losses connected to market risk.
There are many ways to hedge equity, with one of the most common being options contracts that behave in a non-correlated manner in relation to the underlying equity investment. That non-correlation may provide the portfolio diversification investors desire. While hedging is often considered a temporary tactic, long-term investors should consider the benefits of a long-term hedging strategy. They can remain always invested broadly in the equity market to participate in growth where possible, but are always hedged. This approach bridges the gap that the traditional 60/40 portfolio does not.
Financial advisors and long-term investors have made a lot of money over the past decade as the Federal Reserve showered the U.S. economy with highly stimulative, balance-sheet-bloating asset purchases and skinny interest rates. But investors are now facing daunting challenges not seen for decades – both the stock market and inflation-adjusted bond yields are eroding their purchasing power. Those who can steward their portfolios through this treacherous investment landscape with new strategies will benefit immensely. To do so, they must redefine portfolios. They can no longer count on the Federal Reserve.
Randy Swan is the founder and lead portfolio manager of Swan Global Investments, based in Durango, Colorado. Swan Global Investments is an SEC-registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (DRS). Please note that registration of the Advisor does not imply a certain level of skill or training. All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is no guarantee of future results and there can be no assurance that future performance will be comparable to past performance. This communication is informational only and is not a solicitation or investment advice. Further information may be obtained by contacting the company directly at 970-382-8901 or www.swanglobalinvestments.com. 155-SGI-042722
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
